Interest Rate Swaps - Orrick, Herrington & Sutcliffe Library/public/files/4/430... ·...
Transcript of Interest Rate Swaps - Orrick, Herrington & Sutcliffe Library/public/files/4/430... ·...
craig underwooderic h. chuthomas b. foxjon a. mcmahon
roger l. davisstephen a. spitzalbert simons iiigeorge g. wolf
Application to Tax-Exempt Financing
Interest Rate Swaps
DISCLAIMER: Nothing in this booklet should be construed or relied upon as legal or financial
advice. Instead, this booklet is intended to serve as an introduction to the general subject of
interest rate swaps and their related products, from which better informed requests for advice,
legal and financial, can be formulated.
Published by
Bond Logistix LLC and
Orrick, Herrington & Sutcliffe LLP
All rights reserved.
Copyright © 2004 by Bond Logistix LLC and Orrick, Herrington & Sutcliffe LLP
No part of this book may be reproduced or transmitted in any form or by any means, electronic
or mechanical, including photocopying, recording or any information storage and retrieval
system, without permission in writing from the publisher.
interest rate swaps:application to tax-exempt financing
Chapter 1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1
Chapter 2. What Are Swaps and How Do They Work? . . . . . . . . . . . . . . . . . . . .3
Structure of an Interest Rate Swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4The Counterparties’ Perspectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5
Chapter 3. Types of Swaps and Other Hedges . . . . . . . . . . . . . . . . . . . . . . . . . .9
Interest Rate Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9Off Market Swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13Forward Swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14Swaption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15Interest Rate Caps, Floors, Collars . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .16
Chapter 4. Uses and Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19
Asset/Liability Matching . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20Hedging of Interest Rate and Market Risks . . . . . . . . . . . . . . . . . . . . . . . .20Achieving Access to Different Interest Rate Markets . . . . . . . . . . . . . . . . .22Generating Cash Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22
Chapter 5. Business Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25
Provider Credit Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25Termination Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26Collateralization Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26Basis Risk and Tax Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27
Chapter 6. How to Acquire a Swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29
The Bidding Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .30Pricing and the Swap Advisor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .33Swap Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .34
Chapter 7. Legal Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .35
Legal Authority . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .35Constitutional Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .36Sources of Payment and Security . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .36Integration with Bond Documents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37Bankruptcy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .38
Chapter 8. Tax Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39
Qualified Hedges – Regular Integration . . . . . . . . . . . . . . . . . . . . . . . . . . .40Qualified Hedges – Superintegration . . . . . . . . . . . . . . . . . . . . . . . . . . . . .43Anticipatory Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45
Chapter 9. Documentation and Negotiation . . . . . . . . . . . . . . . . . . . . . . . . . . .47
Documentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .47Major Points of Negotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48
Chapter 10. After the Close: Post-Trade Management . . . . . . . . . . . . . . . . . . .53
Financial Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .53Risk Monitoring . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .54Accounting and Disclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .54
Glossary of Key Swap Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .57
About the Authors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .62
1
chapter one
Introduction
The global interest rate swap market is remarkably vast, both in terms of size and
scope of products, and it continues to grow rapidly. Within the U.S. public finance
sector, the use of interest rate swaps and their close relatives is becoming more
common as increasing numbers of governmental entities utilize them to reduce their
borrowing costs, better manage or limit their interest rate risk, and effect better
matching of assets and liabilities. Written for the benefit of issuers of tax-exempt
debt (referred to herein as “Agencies”) and other entities that have access to the
municipal capital markets, this booklet serves to help Agencies enhance their
understanding of interest rate swaps and related financial tools.
Included is an overview of common types of swaps and discussions of how they
work. Additional topics addressed are transaction mechanics and documentation,
potential benefits and risks, legal and tax issues, and post-trade management. Special
emphasis is placed on the most common type of transaction, the so-called “fixed rate
swap,” in which an Agency receives a floating rate and pays a fixed rate. When
combined with an issue of floating rate bonds, this swap is intended to create a
structure which, on a net basis, results in synthetic fixed rate debt for the Agency.
Like other areas of finance, the swap industry has developed its own terminology
to describe the financial and legal terms of a transaction in a practical and concise
manner. Several of the most commonly used terms are listed in the Glossary of Key
Terms at the end of this booklet.
This booklet is a joint effort of Bond Logistix LLC (“BLX”) and Orrick, Herrington
& Sutcliffe LLP (“Orrick”). BLX is a financial and investment services advisory firm,
dedicated to governmental and other users of tax-exempt debt. BLX maintains an
2 interest rate swaps:
active swap advisory and monitoring practice in addition to investment advisory
and brokering, arbitrage rebate compliance, continuing disclosure and program
administration practices. Orrick is a global, full-service law firm with a finance
emphasis. Over the past decade Orrick has ranked number one in the country as
bond counsel and has represented numerous governmental issuers and swap providers
in hundreds of swap transactions of every type. Orrick attorneys have also crafted
legislation authorizing swaps and other hedging instruments in a number of states.
application to tax-exempt financing 3
chapter two
What Are Swaps and How Do They Work?
An interest rate swap is a contractual agreement between two parties who agree to
exchange (or “swap”) certain cash flows for a defined period of time. Generally, the
cash flows to be swapped relate to interest to be paid or received with respect to some
asset or liability. Accordingly, the swap is designed to generate a net change in the
interest rate cash flow related to that asset or liability (typically investment securities
or bond indebtedness, respectively), but neither impacts the principal of that asset
or liability nor results in the creation of any new principal. As a result, the size of
a swap, for purposes of describing the computational base on which the swapped
payments are calculated, is referred to as the “Notional Amount.” As part of any
swap, both parties agree to (i) the Notional Amount, (ii) the rate or rate formula
each party will use to compute the amounts to be paid to the other on that Notional
Amount, (iii) the dates on which cash flows will be exchanged, and (iv) the term of
the swap.
Interest rate swaps do not typically generate new funding like a loan or bond sale;
rather, they effectively convert one interest rate basis to a different basis (e.g., from
floating to fixed). There are also swap variations which are structured to have an
up-front payment made from one party to the other. Such swaps, or “off-market”
swaps, can be a useful tool when an Agency’s financing objective includes the need
for additional, up-front cash. However, an Agency should consider the fact that such
a swap can be characterized as having an embedded loan. Chapter Three discusses
these off-market swaps in greater detail and Chapter Seven addresses the additional
legal issues that they present.
Whether entering into a plain vanilla fixed rate swap, or one tailored to a set of
special circumstances, Agencies should note that issuing variable rate bonds and then
4 interest rate swaps:
entering into a fixed rate swap is not the same as issuing fixed rate bonds, even though
the Agency’s future debt service obligations should be similar under both. Figure 1
compares a conventional fixed rate bond issue arrangement to a swap transaction
creating a synthetic fixed rate which, in fact, involves two separate transactions.
Fixed Rate Bonds
fixed rate
AgencyBond
Holders bond sale proceeds
Variable Rate Bonds and Floating to Fixed Rate Swap
SwapProvider
Swap
fixed rate AgencyBond
Holdersbond sale proceeds
Bonds
swap variable rate bond variable rate
Structure of an Interest Rate Swap
Each swap transaction has its own terms and features, but the typical interest rate
swap used in the municipal marketplace provides that one party’s payments are calculated
using a fixed rate (the “Fixed Leg”) while the other party’s payments are calculated using
a variable rate (the “Floating Leg”). The swap documentation identifies:
• the set fixed rate;
• the specific variable rate index;
Figure 1
application to tax-exempt financing 5
• the Notional Amount (including any scheduled increases or more likely,
decreases or amortization);
• the dates of cash flow exchange;
• the conditions of optional and mandatory termination; and
• the scheduled termination date, which defines the term (sometimes referred to as
the “tenor”).
The fixed rate is generally set for the term of the swap. The variable rate can be
based on any index (e.g., BMA Index or LIBOR), or even a specific security (e.g.,
an Agency’s variable bond rate). The underlying index, or other instrument, from
which the Floating Leg payments are calculated is known as the “Underlying.”
If scheduled to occur on the same dates, the fixed payment by one party is netted
against the floating payment by the other, such that only a net settlement is made
by one of the parties on a given payment date. These exchanges take place on the
pre-established payment dates and reflect the differences between the two rates
during the applicable period.
The Counterparties’ Perspectives
In the municipal marketplace, the two parties to a swap are the Agency (or, in
the case of a conduit bond deal, the conduit borrower) and a financial institution
(the “Provider”), typically a commercial bank, an investment bank, or an insurance
company (or a subsidiary of one of these entities). While the Agency accomplishes
some financial goal (e.g., hedging variable rate exposure, improving asset/liability
matches, reducing borrowing costs, etc.) by entering into the swap, the Provider will
be compensated for establishing its own hedges and the on-going costs of carrying
the swap on its books.
6 interest rate swaps:
The Provider’s Perspective
Providers typically enter into particular interest rate swaps as part of a large,
hedged portfolio. To illustrate, a Provider might enter into swap transactions with
two different Agencies of similar credit, with matching variable interest rates,
Notional Amounts, and terms. The Provider would be the receiver of the variable
interest rate in one transaction and the payer in the other. However, for the
transactions to be economically feasible for the Provider, there needs to be a
difference in the fixed rate components of the swaps. For example, if in the first
transaction the Provider is obligated to make payments computed using a fixed rate
of 5.00%, the Provider would look to structure the second transaction to receive
5.00% plus a spread. This way, the Provider will earn that fixed spread, or “bid/ask
spread”, between the two agreements.
Even with the use of very sophisticated financial engineering programs, in practice,
Providers are unlikely to be able to achieve a hedge that is completely without credit
and related risks and perfectly matched in terms of both the timing and amounts
of the cash flows. There are some risks to a swap (e.g., counterparty credit risk or
change in tax law risk) that cannot be hedged to any significant degree; that is,
What is a Hedge?
In finance, the term hedge generallyrefers to a tactic (or a financial product)used to offset losses or potential losses associated with an existingfinancial position. For example, a putoption is a hedge that can be used toreduce or eliminate the risk of adverseprice movements in a security. However,the cost of the hedge limits the amountof any future gain on the security aswell. If a hedge completely eliminatesany possible future gain or loss (putanother way, if it eliminates theuncertainty of the security’s return), it is called a perfect hedge.
Specifically, in the case of a fixed rateswap, an Agency’s variable rate debt issaid to be hedged by the swap since, on a net basis, the Agency is paying afixed rate of interest and the swap haseliminated the possibility of having tomake higher (or lower) interest paymentsto its bondholders should short terminterest rates rise (or fall). In this way,the Agency has eliminated any potentialloss (higher rates) or gain (lower rates) onthe variable rate bonds. As discussed inChapter Three, there are varying degreesof hedge effectiveness among commonlyused interest rate swap structures.
application to tax-exempt financing 7
cannot be quantified in dollars with any precision. Additionally, there are other
risks inherent in the swap agreement provisions themselves (e.g., one-way
termination upon downgrade, default by a counterparty to the agreement or the
invalidity or unenforceability of the agreement) that a Provider is also unable to
completely hedge, especially if those provisions differ from completely balanced,
two-way industry norms.
Thus, for the same reasons that a lower credit rating may require an Agency to
issue debt at higher interest rates, an Agency’s swap rate can also be higher than that
of other Agencies with higher credit ratings or if it contains non-traditional swap
terms that are difficult to hedge. Therefore, in a fixed rate swap, the interest rate
the Agency is charged by the Provider will include a component used to offset the
incremental costs for hedging greater risks. The greater the risk perceived by the
Provider, the higher the interest rate that will be charged to the Agency.
Subject to the caveat that there is a limit to the amount of the unhedgeable risk
a Provider can and will take on, swap agreements are very flexible. As mentioned,
features that are difficult for the Provider to hedge (or cannot effectively be hedged)
come at a cost; and there may be features, if analyzed separately, that cost the
Provider more than they can benefit the Agency and therefore may not be to
the Agency’s advantage. Thus, in evaluating and negotiating a proposed swap
transaction, it is important that the Agency be able to delineate the cost components
of the swap and understand not only its own needs and objectives, but also the needs
and objectives of the Provider.
The Agency’s Perspective
Unlike a Provider making its business from earning the bid/ask spread on a
transaction, an Agency generally enters into a swap in order to achieve some specific
financial objective, such as achieving a lower borrowing cost or hedging interest rate
exposure. For example, the most commonly used swap structure – the synthetic
fixed rate transaction – is attractive when the net synthetic fixed rate (the fixed swap
rate plus the on-going costs associated with variable rate debt, taking into account
reasonable assumptions for basis spread and other risks) is lower than the fixed rate
on a traditional fixed rate bond structure. In this scenario, the Agency achieves an
8 interest rate swaps:
important financial objective – lowering its borrowing cost – while maintaining the
predictability of a fixed interest rate. However, as with any financing structure, the
Agency must first evaluate the risks associated with a swap and conclude that they
can be adequately managed and that the swap is otherwise suitable for the Agency.
Conversely, a synthetic variable rate transaction may be attractive if an Agency
wishes to increase the proportion of variable rate exposure in its debt and/or asset
structures in an effort to reduce a mismatch between its assets and liabilities. An
appropriately structured swap can convert fixed rate debt to a variable rate, and
may be the most efficient, and perhaps the only viable, method of reducing such a
mismatch, given the costs and tax limitations associated with restructuring debt and
limitations on investment maturity terms. As with the synthetic fixed rate structure
referenced above, an Agency must compare the costs and associated risks of the
available swap structures with other, perhaps more traditional, financing techniques,
in order to make a prudent, informed decision.
Regardless of structure, an Agency should go beyond the financial analysis required
to determine if a swap will achieve its economic objective and review a proposed swap
transaction with the same level of diligence it would apply to the consideration of
any bond issue. Issues such as rate exposure, basis risk, transaction costs, covenant
obligations, security, redemption or refunding flexibility, termination risk, counterparty
creditworthiness and other similar issues should all be carefully considered prior to
entering into a swap.
application to tax-exempt financing 9
chapter three
Types of Swaps and Other Hedges
Interest rate swaps can be used to achieve goals beyond creating synthetic fixed or
variable rate debt. Agencies seeking to achieve a variety of financing objectives have
a choice between several interest rate swap structures in use today, each having its
own set of features and variations. Swaps can be structured as floating-to-floating
rates swaps, in which one variable rate index is swapped for another (also sometimes
known as a “basis swap”). Additionally, instead of debt, they can be associated with
investment assets in order to effectively convert the interest earned on such investments
from fixed to floating or vice versa. Swap agreements may also incorporate a variety
of features, such as an off-market swap component, which is economically equivalent
to a loan, generally made from a Provider to an Agency. Other features might include
a tax reform trigger event, which is used to hedge against changes in tax law, or an
embedded option, such as a call option. These different types of swaps as well as
other forms more generally described as hedges, are described in the sections
immediately below.
Interest Rate Swaps
As previously mentioned,
an interest rate swap is an
agreement between two
parties to exchange future
cash flows. The term of the
swap and its Notional
Amount will typically
Basic Swap Structures:
• Floating-to-Fixed Rate Swap (“fixed rate swap”)
• Fixed-to-Floating Rate Swap (“floating rate swap”)
• Floating-to-Floating Rate Swap (“basis swap”)
Variations and Other Related Hedges:
• Off-Market Swap
• Forward Swap
• Interest Rate Caps, Floors, and Collars
• Swaption
10 interest rate swaps:
mirror the dates and amounts of the hedged debt or asset. The most common
variations found in tax-exempt financing are (i) the Floating-to-Fixed Rate Swap
(fixed rate swap), (ii) the Fixed-to-Floating Rate Swap (floating rate swap), and
(iii) the Floating-to-Floating Rate Swap (basis swap).
Floating-to-Fixed Rate Swap (fixed rate swap)
As an alternative to issuing fixed rate bonds, an Agency can instead sell floating
rate bonds and simultaneously enter into a receive-floating, pay-fixed interest rate
swap, or fixed rate swap. The goal is to create, on a net basis, a fixed rate obligation.
A key consideration for the Agency will be the formula and floating rate index to
be used in computing its receipts on the Floating Leg of the swap (e.g., % of
LIBOR, % of LIBOR + a fixed spread, BMA Index, or Cost of Funds). The goal
is to select a formula and index that will best match, or hedge, the Agency’s bond
interest payments. To the extent the Floating Leg receipts do not match the variable
rate bond interest payments, the Agency’s net debt service will vary over time and,
accordingly, will result in somewhat higher or lower net debt service payments from
period to period.
Floating-to-Fixed Rate Swap: How fixed is synthetically fixed?
A properly structured swap will providean effective hedge, but more often thannot, a less than perfect one. A perfecthedge would be defined by Floating Legreceipts that match the interest paymentsdue on the hedged bonds exactly, whichis known as a Cost-of-Funds swap. Thisstructure results in a true fixed rate obli-
gation for the Agency, but may not resultin the lowest overall cost of funds. Thisis because market rates charged for theFixed Leg on a Cost-of-Funds swap willbe considerably higher than the FixedLeg of a swap where the Underlying ismore liquid and traded in greater vol-ume, such as the BMA Index or LIBOR.
application to tax-exempt financing 11
Floating Rate Option Scorecard (Agency’s Perspective)
The fixed rate achieved through this structure can be lower than the fixed rate that
can be attained through a traditional fixed rate bond offering. This is especially true
if an Agency structures its swap using a LIBOR-based floating payment in exchange
for a fixed payment. The rate advantage of a LIBOR based swap is the result of a
combination of factors, including the greater liquidity and efficiency of the taxable
Simply put, a Provider can more effec-tively hedge a BMA or LIBOR-basedswap, which is reflected in the ratecharged on the Fixed Leg. For thisreason, Cost-of-Funds swaps have beenrare. Furthermore, Cost-of-Funds swapsgenerally include provisions converting
the swap to an index under certaincircumstances (such as a decline in thecredit quality of the Agency) and may givethe Provider significant control over fac-tors that may influence the Agency’s costof funds (e.g., interest rate mode, remar-keting agent, or similar on-going costs).
An Agency’s net future debt serviceobligations under a synthetically fixedrate structure may not be determinedwith the absolute level of precision of a fixed rate bond issue. However,from a budgeting perspective, absolute
precision is not likely to be essential solong as the Agency understands theunderlying mechanics and factors thatwill affect its net debt service require-ments and the degree to which thoserequirements may vary.
Figure 2
Floating Rate Option
LIBOR
LOWEST
BMA
higher
Cost-of-Funds
Fixed Rate Coupon highest
HIGH medium lowLiquidity
good better BEST (PERFECT*)Hedge Effectiveness
* true synthetic fixed rate
12 interest rate swaps:
swap markets and the Agency’s assumption of basis risk, including change in tax law
risk. Also, because the Agency can generally terminate a swap only at market value
and not at par value, the synthetic fixed rate arrangement should be evaluated against
the cost of noncallable fixed rate bonds as opposed to typical fixed rate bonds with
optional redemption provisions.
Basis Risk, Including Change in Tax Law Risk
The term basis risk refers to the poten-tial or actual mismatch between anAgency’s floating receipt from a swapand its floating payment obligation onthe underlying debt. This mismatchexists when each cash flow referencesdifferent underlying securities or ones ofdiffering maturity terms. For example,every month an Agency might receive apre-set percentage of the one-monthLIBOR rate from the Provider, and payinterest on its tax-exempt variable ratebonds once every 35 days. Both thetiming difference and the fact that inter-est will accrue at different rates, even ifneither is significant, technically resultsin basis spread. Moreover, the magni-tude of the basis spread will vary overtime. It is the cumulative basis spreadover the term of the swap, or more prac-tically over each fiscal year, that will beimportant for the Agency in terms ofcash flow budgeting.
Change in tax law risk, or tax reform risk,is the risk that there will be an unantici-pated structural change to the current taxlaw (e.g., a reduction in marginal incometax rates), which would then impact therelationship (i.e., the spread) betweentax-exempt and taxable rates. This is therisk Agencies undertake whenever theyissue floating rate bonds. It can also canarise in the context of a swap. To illus-
trate, suppose an Agency currently hasoutstanding tax-exempt variable ratebonds at 3.5% as well as taxable vari-able rate bonds at 5.0%. If the marginaltax rate was, for example, reduced from30% to 10%, the yield on the tax-exemptbonds might increase to 4.5%. In thecase of a fixed rate swap wherein theProvider is paying the BMA Index (andreceiving a fixed rate) and the rate onthe Agency’s bonds is substantially thesame as the BMA Index, the Provider isexposed to tax risk because if there is areduction in the marginal tax rates andthe BMA Index suddenly rises, theProvider’s payment obligations underthe swap will increase.
While the Agency’s payment obligationsunder the bonds will also increase, thatincrease will be offset by the increasedswap receipts. On the other hand, if theAgency had entered the same swap, butinstead of receiving payments based onthe BMA Index, it received paymentsbased on LIBOR (70% of one-monthLIBOR for example), the Agency wouldbe exposed to tax reform risk. In thisexample, assuming that if since incep-tion the swap receipts had closelyapproximated the bond interest pay-ments, then a sudden reduction in themarginal tax rate could adversely impactthe Agency.
application to tax-exempt financing 13
Fixed-to-Floating Rate Swap (floating rate swap)
As an alternative to issuing variable rate bonds, the Agency can instead sell fixed rate
bonds and simultaneously enter into a receive-fixed, pay-floating interest rate swap.
The goal is to create, on a net basis, a floating rate obligation.
Basis Swap (floating-to-floating rate swap)
In a basis swap, the Agency enters into a receive-floating, pay-floating interest rate
swap where, for example, the Underlying for the first Floating Leg is the BMA Index
and for the second Floating Leg is based on the one-month LIBOR rate. A basis
swap may be used to reduce risk associated with potential changes in tax law (see
sidebar above), decrease basis risk, or to move from one index to another.
Off-Market Swap
An off-market swap is a variation of an interest rate swap in which one or both of
the referenced rates is priced off the market, resulting in an up-front cash payment,
usually paid by the Provider to the Agency. For example, in the case of a floating to
Figure 3:Synthetic Fixed Rate Debt with a Basis Swap
SwapProvider fixed rate
Agency
BondHoldersproceeds
% of LIBORtax-exempt
variable bond rate
SwapProvider
Basis Swap
% of LIBOR
BMA Index
Floating to Fixed Rate Swap Bonds
Figure 3
14 interest rate swaps:
fixed rate swap, if the coupon rate for the Fixed Leg is set above the market rate, the
Agency would receive an upfront payment from the Provider (which is somewhat
similar to a loan to the Agency which it, in effect, pays back as that portion of the
fixed rate that is above the market rate.)
Forward Swap
Forward swaps are interest rate swaps in which the accrual and exchange of cash
flows commences at a later date (the Effective Date) rather than the current date (on
or around the Trade Date), thereby affording the opportunity to lock in rates today
while accruals begin in the future. While forward swaps allow rates to be locked in,
the rates will be determined via the forward rate curve, which is not the same as the
current yield curve. These types of transactions are often used to approximate the
benefits of an advance refunding when one is not otherwise permitted under tax law.
The forward swap locks in a fixed rate, and then variable rate bonds are issued in
the future as current refunding bonds upon the Effective Date of the swap. Although
mechanically different from a swap, Agencies can achieve similar results by utilizing
what is known as a rate lock agreement, which entails entering into an agreement
with an underwriter to issue fixed rate bonds in the future.
Figure 4:Off-Market Swap vs. On-Market Swap
variable rate
on-market rate
no up-front payment
AgencySwap
Provider
off-market rate
up-front payment
Agencyvariable rateSwapProvider
off-market rate
on-market ratesw
ap r
ate
(%)
basis of up-front payment
term of swap (time)
Rate Differential Determines Up-front Payment
vs.
Figure 4
application to tax-exempt financing 15
Agencies who have entered into a forward swap often determine to optionally
terminate the swap prior to its scheduled Effective Date, and essentially utilize the
forward swap as a cash settlement hedge. If, for example, interest rates have risen
since the Trade Date, the swap is “in the money” for the Agency; that is, if the swap
were terminated the Provider would be required to pay the Agency a termination
amount. Depending on market conditions, including the relationship between the
tax-exempt and taxable yield curves, the Agency might be able to achieve a better
financing result by terminating the swap (and collecting its settlement amount) and
either leaving the bonds that were to be refunded outstanding, or issuing conventional
fixed rate bonds as a current refunding.
Swaption
A swap option, or a “swaption”, is similar to a forward swap in that the swaption
outlines the terms of a swap to be entered into in the future. However, in a swaption,
one party, usually the Provider, has the right, but not the obligation, to enter into (or
modify or cancel) that swap with the other party, the Agency, at a specified fixed rate
and floating rate formula, on a specified date or during a specified period in the future.
In exchange for that right, the Provider will pay an option premium to the Agency
on the Trade Date, which can be months or years prior to the swap’s potential
Effective Date.
Figure 5:
Forward Starting Swap (Synthetic Advance Refunding)
today first call dateof high coupon bonds
final maturity
execute forward
swap—lock in fixed rate
• issue floating rate bonds and call high coupon bonds
• floating to fixed rate swap commences
high coupon bondslow coupon on swap
Figure 5
16 interest rate swaps:
This structure is sometimes used in connection with the refinancing of debt that
cannot be advance refunded because of tax law restrictions. In such a case, the fixed
rate on the swap that underlies the option is the “strike rate” (which might be
structured to equal the average coupon on the outstanding bonds) and the Provider
may only have a limited time frame (on or just before the first call date of the
bonds) to exercise its option. If the Provider exercises its option, the Agency will
issue variable rate bonds at that time, call the outstanding bonds, and on a net basis
have a synthetic fixed rate as a result. The payments associated with that fixed rate
will be approximately the same as prior to the swap. The option premium received
by the Agency then would be reflective of the Agency’s refunding savings. If the
Provider does not exercise its swaption, the Agency will have received its premium
while retaining the ability to call the old debt at a later date and, therefore, may
have yet another opportunity to refund those bonds.
Option or Obligation?
An Option is a contract that provides the right, but not the obligation, to enter into or effect a transaction for pre-specified terms within a predeterminedtime period, or Exercise Period. Theentity that sells the option (and usuallyreceives an upfront payment inexchange), has an obligation to fulfill theterms of the transaction if the option is
exercised. The Exercise Period can vary from a single date in the future (aEuropean option), to a series of single,periodic dates (a Bermuda option), toany date within a specified date range(an American option). Agencies thatutilize these tools should be aware ofthe associated obligations that mayarise in the future and plan accordingly.
Interest Rate Caps, Floors, and Collars
An interest rate cap is a hedging tool that protects the purchaser of the cap from
rises in short-term interest rates through receiving a payment from the Provider
when the interest rate on the Underlying exceeds a specified strike rate (the “cap
rate”). By contrast, in the case of an interest rate floor, the Agency would receive a
application to tax-exempt financing 17
premium and would be obligated to make payments to the Provider to the extent
the strike rate (the “floor rate”) exceeded the rate on the Underlying. An interest rate
collar is a combination of both an interest rate cap and interest rate floor which
can be structured such that the cap premium and floor premium offset each other
and, therefore, on a net basis, no premium(s) are paid by the Agency. Similar to an
interest rate swap, basis risk will exist to the extent the rate on the Underlying does
not equal the Agency’s bond interest rate in any given period. Figure 6 below shows
an example of an interest rate cap (with a strike rate of 4.75%) and an interest rate
floor (with a strike rate of 2.25%) and, when combined, the two represent an interest
rate collar.
Figure 6:
Interest Rate Cap, Floor and Collar
1 month LIBOR
Jan-
93
Jan-
94
Jan-
95
Jan-
96
Jan-
97
Jan-
98
Jan-
99
Jan-
00
Jan-
01
Jan-
02
Jan-
03
Jan-
04
7%
6%
8%
5%
4%
3%
2%
1%
0%
agency receives LIBOR-4.75%
agency pays LIBOR-2.25%
effe
ctiv
e d
ate
2.25% rate floor
rate collar
4.75% rate cap
Figure 6
Agency receives LIBOR-4.75%
Agency pays LIBOR-2.25%
application to tax-exempt financing 19
chapter four
Uses and Benefits
Although a swap does not itself represent debt, it is usually tied to one or more debt
issuances. As such, swaps are used to change the economics of existing or future
debt without changing the size or structure of the debt itself. When used as part
of a coherent strategy, swaps provide access to different markets and more flexible
structures than have been historically available to Agencies when straight fixed rate or
variable rate debt were the only options. Swaps can also be entered into for any term,
and can therefore be useful for addressing near-term cash flow and other liability
management needs, for example, during the construction period of a debt-financed
project in which an Agency does not wish to change the underlying structure of
outstanding long-term debt.
Swap structures are most commonly explored because of the potential reduced
borrowing costs, but entering into a swap agreement can benefit an Agency in
other ways. Beyond any cost savings, the uses and benefits of debt-related swaps
by Agencies can generally be described as falling into four broad categories:
• swaps afford increased flexibility in the design of an Agency’s asset/liability
matching strategy;
• swaps serve as a way to hedge certain interest rate and market risks;
• swaps can enable an Agency to access interest rate markets otherwise either
unavailable or unattractive with traditional debt structures; and
• swaps can be used to generate cash payments to the Agency in exchange for
certain adjusted terms or options sold to the Provider.
20 interest rate swaps:
Asset/Liability Matching
Agencies are becoming increasingly attentive to comprehensive asset/liability
management strategies. Historically, debt and investment decisions were often made
independently of each other, and governmental agencies typically borrowed at long-
term fixed rates and invested at short-term rates. Particularly in an interest rate
environment where the yield curve is steep, Agencies with significant funds invested
short-term have felt the adverse impact of a debt strategy which does not account for
such an environment. With their relative ease of structuring, implementation, and
termination, swaps can be a useful tool in restructuring the debt side of an Agency’s
balance sheet to better reflect certain asset positions. Such a unified and coordinated
strategy can allow an Agency to use either side of the balance sheet to more readily
anticipate uncertain cash flow needs that might be presented by the other side.
Hedging of Interest Rate and Market Risks
The most common type of debt-related swaps are floating-to-fixed and fixed-to-
floating rate swaps. In the first scenario, a swap is used to create a synthetic fixed rate
obligation where the underlying debt is variable. This presents an alternative to
issuing true fixed rate debt by allowing the Agency to utilize the short-term capital
markets while not exposing it to interest rate risk. Under certain market conditions,
influenced by factors such as the steepness of the yield curve, credit spreads, and
current or expected income tax rates, true fixed rate debt will carry a higher interest
cost, and so a floating-to-fixed rate swap can serve to lower the borrowing costs of
the debt. Such swaps are also useful when an Agency wishes to convert existing
variable rate debt to a fixed rate obligation without the time and costs of a bond
refunding. This is particularly common when an Agency anticipates a future period
of rising interest rates, and wishes to limit its variable rate exposure in connection
with given debt for a certain period of time.
application to tax-exempt financing 21
In the fixed-to-floating rate swap scenario, synthetic variable rate debt is created
where the underlying debt is fixed. In this context, an Agency is able to create
variable rate debt exposure without the traditional costs of true variable rate debt
(e.g., liquidity, letter of credit, or remarketing fees, etc.) and without exposure to the
risk the bonds will be tendered by their holders and not remarketed. In this way, an
Agency can also achieve a better matching of a given bond issue’s short-term assets
with the debt, thereby mitigating the risk of significant negative arbitrage on large
cash balances. Additionally, this structure is useful for certain borrowers that are
unable to easily acquire the necessary insurance or liquidity support for true variable
rate debt.
When structured on a forward basis, a floating-to-fixed swap can be used to hedge
against rising interest rates. This can be particularly valuable in the context of large
or long-term debt restructurings. For example, a forward funding swap can enable
an Agency to achieve a synthetic advance refunding of fixed rate debt when it is
otherwise precluded from doing so by the tax rules limiting advance refundings. By
entering into a forward swap today, an Agency can lock in today’s fixed rates, while
the swap payments do not actually begin until after the call date of the old bonds.
At that point, variable rate current refunding bonds are issued, and the Agency has
thereby replaced the old true fixed rate debt with synthetic fixed rate debt at today’s
rates (but determined via the forward yield curve). This provides an effective hedge
against interest rate risk if an Agency considers today’s environment to be favorable,
and is concerned that such an environment might no longer exist once the call date
of the old debt is reached.
An important element of swaps is the ease with which they can be terminated
or renegotiated. Early terminations can be motivated by the desire to regain the
exposure of the underlying debt structure, or the opportunity to monetize a market
gain on the swap. Some Agencies have a swap management strategy to terminate
the swap (in whole, or in part) when a significant termination fee would be owed
to the Agency and then subsequently replace the swap when interest rates cycle in
the opposite direction.
22 interest rate swaps:
Achieving Access to Different Interest-Rate Markets
Swaps are frequently used to lower an Agency’s borrowing costs by providing
access to interest rate markets otherwise unavailable or unattractive with traditional
debt structures. For example, while the traditional tax-exempt fixed income market
generally provides governmental issuers access to cheaper capital than its taxable
counterpart, the greater liquidity and flexibility of the swap market can often present
even more borrowing cost savings opportunities. Also, in certain interest rate
environments (e.g., historically low rates), the difference, or “compression,” between
taxable and tax-exempt rates can increase the pricing advantage of synthetic fixed
rate bonds over traditional fixed rate bonds. As will be discussed in Chapter Five,
when considering these relative advantages, Agencies must carefully analyze the
possible impact of basis cost and the potential that it might reduce and/or eliminate
the projected cost advantage. Further, swaps can allow an Agency to diversify its
exposure to different markets, which is often a goal in and of itself.
The creation of synthetic fixed rate or variable rate debt can also enable an
Agency to maintain some characteristics of one type of debt while accessing some
characteristics of another. This allows the Agency to optimize its debt positions
while also simplifying its overall asset/liability position.
Generating Cash Payments
While most swaps contain defined commencement and maturity dates, it can be
advantageous for an Agency to sell one or more options to the Provider relating to a
swap or potential swap. Two examples of these are options to extend and options to
cancel (or suspend) the swap. In either case, the option gives the Provider increased
flexibility in the future management and maintenance of the swap, which may be
valuable in certain changing interest rate environments. The benefit to the Agency
may come in the form of an increased rate on its receipt under the swap (or decreased
rate on its obligation under the swap). Alternatively, these options can be monetized
in whole or in part in the form of a cash payment to the Agency upon execution of
the swap.
application to tax-exempt financing 23
A swap can also be structured such that the Agency’s obligation under the swap is
greater (or its receipt is lower) than would otherwise be the case (i.e., its payment
obligations are above the current market). This is an off-market swap, and is
characterized by the Agency receiving an up-front payment from the Provider in
exchange for higher future net swap payments from the Agency.
Another way to generate cash is through the use of a basis swap (see Chapter
Three for further explanation of basis swaps) with an up-front payment. This can
be a stand alone structure or it can be layered on top of a floating-to-fixed rate swap.
This is most appropriate when the Agency either (i) is comfortable that the up-front
payment outweighs the basis risk being assumed, or (ii) already has a basis position
to be neutralized by the basis swap.
An additional way to generate a cash payment today is to enter into a swaption,
under which the Provider is sold the option to enter into a swap over a given term
(see Chapter Three for more on swaptions).
application to tax-exempt financing 25
chapter five
Business Risks
When entering into a swap, the Agency anticipates that the Provider will honor
its obligations for the full term of the swap (unless the Agency exercises its early
termination option). Further, when entering into a synthetic fixed rate swap,
to convert variable rate debt to a fixed rate
obligation, the Agency expects that the variable
rate payments it receives under the swap will
closely approximate the interest rate on the
related debt. There are risks, however, that such
expectations will not be fulfilled.
Provider Credit Risk
The value of a swap to the Agency depends on the ability of the Provider to meet its
payment obligations under the swap. This risk is addressed, though not eliminated,
by requiring some level of Provider credit (e.g., AA/Aa2 or A/A2) as a condition to
entering into a swap. Provider credit can often be enhanced through an unconditional
guarantee by an affiliate of the Provider. Credit risk can also be addressed with
collateralization requirements and/or provisions that, in the case of Provider
downgrade, allow for termination of the swap, or require a transfer or assignment of
the swap to a creditworthy Provider (See Chapter Nine regarding Credit Annex).
Business Risks
• Provider Credit Risk
• Termination Risk
• Collateralization Risk
• Basis Risk and Tax Risk
26 interest rate swaps:
Termination Risk
Swap agreements allow for termination of the swap in the case of certain
“termination events.” Such events may include, in addition to payment defaults
on the swap, adverse credit indicators such as a downgrade or a cross default on
other obligations, force majeure, a challenge to a party’s legal obligation to perform
its obligations under the swap beyond the parties’ control, or other factors. If there is
an early termination, one party will owe the other a termination payment reflecting
the valuation of the swap under then-current market conditions. If market rates
have changed to a party’s disadvantage (e.g., if the party is a fixed rate payer and
interest rates decline), or even if rates have not changed but the party received an
up-front payment on an off-market swap, that party will be “out of the money” on the
swap and will owe the other party a termination payment. A termination of a swap,
therefore, could result in a substantial unanticipated payment obligation on the part
of the Agency. This risk can be addressed to a degree through credit enhancement of
the Agency’s obligation and swap agreement provisions basing termination events on
the credit of the credit enhancer as opposed to the Agency. Because swap agreements
generally provide for “two-way” termination payments at market value, an Agency
may be obligated to make a substantial payment even if termination is the result of
Provider default or deterioration of the Provider’s credit.
Collateralization Risk
Swap agreements often require a party that is out of the money on a swap above
a negotiated threshold to post collateral even if that party is performing and no
termination event has occurred. This may be burdensome for an Agency and may
raise significant legal issues. Since collateralization thresholds are tied to credit ratings,
collateralization risk can also be addressed in part through credit enhancement.
application to tax-exempt financing 27
Basis Risk and Tax Risk
When an Agency enters into a swap in connection with variable rate debt, for any
payment period the variable rate received by the Agency under the swap (calculated
in accordance with the terms of the swap agreement) may be either greater than or
less than the interest rate paid by the Agency on the underlying debt. The potential
for a disadvantageous mismatch is known as “basis risk.”
If the variable rate payable to the Agency under the swap is calculated based on a
taxable index (e.g., a percentage of LIBOR) and the related debt is tax-exempt, then
the Agency is also exposed to “tax risk,” the risk that the spread between taxable and
tax-exempt rates will be less than anticipated (perhaps because of a reduction in
marginal tax rates).
Figure 7:BMA Index vs. 67% of One-Month LIBOR: Historical Comparison
BMA Index 67% of 1 month LIBOR
Jan-
90
Jan-
91
Jan-
92
Jan-
93
Jan-
94
Jan-
95
Jan-
96
Jan-
97
Jan-
98
Jan-
99
Jan-
00
Jan-
01
Jan-
02
Jan-
03
Jan-
04
7%
6%
5%
4%
3%
2%
1%
0%
Figure 7
28 interest rate swaps:
Basis risk and tax risk can be addressed by structuring the swap as a “cost of
funds swap”. Cost of funds swaps are uncommon, however, since (i) pricing is
not as efficient as with an index-based swap, (ii) the Agency must generally cede
some control over the administration of its debt (e.g., interest rate mode changes,
monitoring of remarketing agent performance) to the Provider, and (iii) cost of funds
swaps generally convert to an index-based swap under certain adverse circumstances
(e.g., Agency credit event, challenge to tax-exemption of the debt).
application to tax-exempt financing 29
chapter six
How To Acquire a Swap
The emergence of swaps has introduced an additional complexity to the issuance of
public debt, which is already complicated by a myriad of federal and state rules and
regulations. Along with the real world benefits of the prudent use of swaps comes the
responsibility of understanding the mechanics, benefits, and perhaps most important,
the risks. Thus, because of the added intricacies that a swap can bring to tax-exempt
financing, there are additional issues that an Agency must consider when entering
into a swap agreement beyond those of a traditional issue of tax-exempt debt.
When an Agency undertakes to issue new tax-exempt debt, one of its first and
most important tasks is to assemble the appropriate financing team. In the case of a
traditional offering, a financing team usually consists of the Agency, underwriter(s),
bond counsel, financial advisor, disclosure counsel, and trustee. However, given the
unique and specialized nature of swaps, if a swap is utilized in a debt offering, the
Agency may wish to add a Swap Advisor and/or swap legal counsel to the financing
team. It is not unusual for some bond counsel and financial advisory firms to lack the
required expertise to advise issuers on the specifics of swap structures, documentation,
and pricing. In these instances, the Agency will often supplement the financing team’s
capabilities with firms possessing substantial swap expertise. A Swap Advisor can
offer an Agency a diverse line of services tailored to help the Agency analyze, develop,
and implement a comprehensive swap strategy. Such services include: development
of internal swap utilization policies; independent evaluation of proposed interest
rate swap structures; risk assessment and stress-testing evaluation; swap structuring
and pricing services; competitive bidding services; swap documentation review and
30 interest rate swaps:
consulting; fair market pricing certification;
termination valuation and negotiating services;
and swap position monitoring and reporting
services. With specialized expertise in the swap
industry, a Swap Advisor often proves to be an
invaluable tool employed by Agencies seeking
to maximize the benefits of utilizing swaps as
part of a diversified asset and liability portfolio.
The Bidding Process
An Agency has two basic approaches to acquiring, or entering into, an interest
rate swap: (i) conduct a competitive bid process, or (ii) negotiate the terms with a
pre-selected Provider.
As with the sale of bonds or other governmental debt, the advantages and
disadvantages of the competitive versus negotiated transaction are debatable
and difficult to quantify given the complexities of today’s financial markets. With
appropriate prudence and safeguards, an Agency can acquire a fairly priced swap
with either approach.
Competitive Bid
Once an Agency has concluded that entering into a swap agreement is a prudent
option to achieve its financial objectives (e.g., hedging interest rate exposure,
improving asset/liability matches, achieving a lower borrowing cost, etc.), its first step
is to work with its Swap Advisor to draft a comprehensive “bid package” for eventual
dissemination to qualified bidders. Qualified bidders would typically consist of
appropriately experienced and creditworthy institutions which also qualify under the
Agency’s general policy standards.
The bid package would typically include:
• a description of the Agency’s financing plan;
Roles of the Swap Advisor:
• Transaction Structuring
• Pricing Negotiations
• Document Review
• Competitive Bidding
• Pricing Certification
• Ongoing Monitoring
application to tax-exempt financing 31
• a term sheet with the desired terms of the swap (which can be very detailed in
order to avoid protracted negotiation over the swap documentation and should
address all of the terms likely to be included in the swap documents that are
material to the Agency);
• relevant information on the Agency’s credit.
The term sheet might include the following:
Once a draft bid package has been circulated and commented on by the Agency’s
financing team, including legal counsel, the Agency and/or its Swap Advisor would
then distribute the draft bid package to qualified Providers. Circulating a draft bid
package allows the Agency to solicit feedback and address any concerns that the
Provider community may have regarding the Agency’s credit and/or financing plan.
Often the feedback received during this pre-marketing effort can provide the Agency
with important structuring considerations for its overall financing plan. For example,
GENERAL
Counterparty Party A (Provider) [to be awarded]
Counterparty Party B (Agency) City of Anytown
Notional Amount See Exhibit A [typically the bond amortization]
Currency US Dollars
Trade Date January 15, 200__
Effective Date February 1, 200__
Termination Date February 1, 203__
FIXED AMOUNTS
Fixed Rate Payer Agency
Fixed Rate Option [to be awarded]
Fixed Rate Payment Dates August 1 and February 1 beginning August 1, 200__
Fixed Rate Day Count Fraction: 30/360
FLOATING AMOUNTS
Floating Rate Payer Provider
Floating Rate Payer Payment Dates 1st day of each month beginning March 1, 200__
Floating Rate Option 67% of the USD-LIBOR-BBA (one-month maturity)
Floating Rate Day Count Fraction: Actual/Actual
32 interest rate swaps:
less creditworthy Agencies may benefit from swap dealer feedback to determine the
additional cost of their “credit penalty” and the advisability of credit-enhancing the
swap through either third-party insurance or some type of collateral arrangement
(referred to as a credit support annex), much like evaluating bond insurance.
After receiving feedback from an adequate number of interested swap dealers and
reasonable assurances of sufficient interest, the Agency would schedule a formal bid
and circulate the final terms it desires. On the bid date, swap dealers submit bids and
the swap is entered into with the winning bidder.
If an Agency is offering to pay a fixed rate and receive a floating rate, the winning
bidder will be that conforming bidder which is willing to accept the lowest fixed
payment in exchange for the desired floating payment. If an Agency is offering
to pay a floating rate and receive a fixed rate, the winning bidder will be that
conforming bidder which is willing to pay the highest fixed rate in exchange for
receiving the floating payment. Often, dealers will submit conditions with their bids.
In these instances, the Agency and its financing team must evaluate the conditions
of each bid to determine if it still conforms to the terms of the bid process.
Once a winning Provider has been selected, the Provider offers draft documents
detailing the terms and conditions of the swap (see Chapter Nine for an overview
of swap documentation). The Agency and its financing team then review the draft
documents and negotiate any specific terms that they might find objectionable or
absent from the documents. Once these negotiations are complete, the Agency and
the Provider will execute the swap documents and the exchange of payments will
commence as prescribed.
Negotiated Bid
As with a negotiated sale of bonds, where an Agency negotiates the debt structure
and cost with an underwriter, an Agency can select a single swap dealer (or limited
group of dealers) with which it can negotiate the terms of an interest rate swap. The
selection of a Provider in a negotiated swap transaction is usually based on a number
of factors including past relationships, special expertise, experience, size and overall
application to tax-exempt financing 33
capabilities, creditworthiness, innovative ideas, fees, etc. An Agency should consider
all of these factors prior to selecting the Provider in a negotiated swap transaction.
Typically, an Agency will utilize an interest rate swap in connection with a debt
financing. In such cases, the Agency often selects its senior bond underwriter as the
designated Provider. The senior underwriter structures the swap as an integrated
part of the overall financing plan, and collects a fee for its usual underwriting and
structuring services, while also being compensated for its principal position as the
Provider.
Once financing and swap structures have been settled upon, the Agency and its
underwriter will set a pricing date on which the bonds and the swap will be priced.
The underwriter, acting as the swap dealer, will offer the Agency the swap at a price
that it deems to be fair market.
Once the Agency has accepted an offer for the swap pricing, the underwriter
provides draft documents setting forth the terms and conditions of the swap.
After reviewing these documents and negotiating the final terms, the Agency and
underwriter execute the final documents and the swap commences.
Pricing and the Swap Advisor
As mentioned previously, a recently emerging role in the public finance industry
has been that of the Swap Advisor. Given the complexities and nuances of the swap
market, many Agencies have elected to utilize the specialized skills and capabilities
of a Swap Advisor whose responsibilities can include a wide range of services, such as
policy development, transaction structuring, pricing negotiations, document review,
competitive bidding, pricing certification, and ongoing monitoring.
Of all the elements to a swap transaction that these services address, perhaps
the most important is pricing. While transparency in the pricing of vanilla swap
transactions has improved significantly, the pricing on transactions that include more
exotic elements can differ significantly from one swap dealer to another. In order
34 interest rate swaps:
for an Agency to be secure that it is entering into a swap at a fair market price, it is
important that some criteria or process for establishing the fair market price for its
swap be in place. In addition to using publicly available or subscription-based pricing
data (e.g., Bloomberg), a Swap Advisor will monitor the prospective Providers’
pre-trade date pricing indications and then advise the Agency on final pricing.
Also, post-trade, Agencies will generally need ongoing pricing updates (“marked-
to-market”) on existing swap transactions for accounting purposes (see Chapter Ten
regarding Accounting).
Swap Policies
It is increasingly considered prudent financial management for governmental
entities considering the use of an interest rate swap to put into place a written swap
policy. Such a policy should be approved by the entity’s governing body and clearly
address the following:
(1) the entity’s rationale for utilizing interest rate swaps
(2) permitted instruments
(3) approved transaction types
(4) risk and benefit analysis procedures
(5) procurement and execution procedures
(6) counterparty eligibility requirements
(7) collateral requirements
(8) documentation requirements
A Swap Advisor and legal counsel expert in swap transactions can assist in the
development and implementation of swap policies.
application to tax-exempt financing 35
chapter seven
Legal Issues
Public agencies, unlike other entities, are characterized by limited powers and
compartmentalized revenues and obligations. State constitutions and statutes can
raise challenging issues and care must
be exercised in the integration of swaps
with an Agency’s other obligations, in
particular the Agency’s debt.
Legal Authority
In states, or for particular entities, that do not have legislation granting express
authority to enter into swap agreements, an Agency’s authority to enter into a
swap must be derived from that Agency’s general power to enter into contracts in
furtherance of its governmental purposes. Often the particular statute authorizing
the related bonds may also authorize other actions necessary or appropriate in
connection with issuing the bonds.
A number of states, however, do have statutes expressly authorizing public agencies
(or certain types of public agencies) to enter into swaps and similar transactions. Such
statutes often impose procedural requirements. Public agencies may, for example,
only enter into swaps following a determination by the Agency’s governing body
that the proposed swap is designed to achieve one of the purposes specified in the
authorizing statute (e.g., reducing interest rate risk, lowering the cost of borrowing,
enhancing the relationship between risk and return on investments). Some states
require Providers to satisfy various credit criteria.
Legal Issues:
• Authority to Enter Into Swaps
• Sources of Payment and Security
• Integration with Bond Documents
36 interest rate swaps:
Constitutional Issues
In addition to concerns about legal authority to enter into swaps, constitutional
issues may arise as well. For example, in the case of public agencies subject to
constitutional debt limits, when the Agency’s obligations under a swap are payable
from the Agency’s general fund, as distinguished from enterprise revenues, such
obligations might qualify for the broadly recognized special fund exception to the
debt limit. Interest rate swaps are unique. They are unlike debts, investments,
insurance, or anything else, and there is very little case law analyzing how swaps,
or certain swap features (such as an obligation to pay a termination payment) are
to be treated for such legal purposes. Counsel asked to opine that a particular swap
is not a prohibited indebtedness must evaluate carefully both the particulars and
the overall economic substance of the transaction and in some cases may require
structural changes to certain swap provisions (e.g., eliminating or qualifying the
Agency’s obligation to make a termination payment to a defaulting Provider or
subjecting the Agency’s payment obligation to an appropriation contingency). In
most cases, however, state constitutional debt limitation issues have a greater effect
on the swap opinion than on the swap itself.
Sources of Payment and Security
It is common and generally appropriate for an Agency’s obligations under a swap
agreement to be payable from the same source as the debt or asset to which the
swap relates. If a swap is entered into in connection with an Agency’s general fund
debt or with respect to the investment of general fund assets, for example, the
Agency’s obligations on the swap are usually payable out of the Agency’s general
fund. If the swap is entered into in connection with debt issued under an Agency’s
master trust indenture, it is appropriate for the Agency’s obligations on the swap to
be secured by such master indenture; and if a swap is entered into in connection
application to tax-exempt financing 37
with the debt or investments of an Agency’s enterprise fund, the Agency’s obligations
on the swap would normally be payable solely out of the revenues of such enterprise.
Swap documents should limit the Agency’s obligations accordingly. Similarly, cross-
default and credit events (usually included in termination events) should be limited
to the same source of funds.
Further, with respect to swap obligations payable from enterprise revenues, the
priority of payment versus other obligations payable from such revenues must be
specified. Often revenues have been pledged to secure bonds and the swap either
cannot qualify as a parity obligation or it is not desirable to treat it under the
additional indebtedness or rate covenant tests. Accordingly, many swaps are secured
by and payable from revenues on a subordinate basis to the bonds. Many modern
indentures specifically contemplate parity swaps. However, even in those cases,
because a termination payment on a swap could be a significant lump sum and could
distort debt service coverage ratios, and even the ability to pay debt service on the
bonds, it is common for termination payments on a swap to be payable on a basis
subordinate to the payment of regular swap payments and enterprise revenue debt.
Integration with Bond Documents
Provisions relative to payments and receipts on swaps entered into in connection
with bonds or other debt obligations should be integrated into the bond documents.
This is of particular importance if the intention is to produce synthetic fixed rate
debt by combining a swap with variable rate debt (see Chapter Three for Floating
to Fixed Rate Swap). An indenture executed and delivered in anticipation of a swap
should provide for regular swap payments on a parity with debt and should treat
amounts received on swaps as a reduction in debt service (as opposed to an addition
to revenues). Otherwise, debt service coverage calculations will not reflect the
integration accurately.
38 interest rate swaps:
Bankruptcy
Should the Provider go into bankruptcy, or become the subject of some other
type of insolvency proceeding, the Agency may face a number of different risks.
The Provider may be able to repudiate the swap and refuse to perform further. The
Provider may have a period of time in which to decide whether or not it wants to
continue to perform, and it may be able to suspend its performance while it makes
that decision. The Provider may be able to transfer the swap to another Provider
without the consent of the Agency, even if the transfer is in violation of the terms
of the swap. In addition, the Agency may be required to continue performing under
the swap even though the Provider is not required to do so. The netting provisions
of the swap may not be enforceable. The Agency may be required to return all
payments that it has received under the swap for a specified period of time prior to
the bankruptcy or insolvency; such period may be as long as one year. The Agency
may be required to return the collateral that secures the swap. The Agency may be
unable to foreclose on any collateral securing the swap without court permission,
and the court is not required to give its permission. Similarly, the Agency may
be unable to take any other action to enforce the provisions of the swap without
court permission. The Agency may not be able to terminate the swap, even if the
swap provides that it can be terminated upon the bankruptcy or insolvency of the
Provider. There are a number of other possible risks associated with the bankruptcy
or insolvency of a Provider and the bankruptcy and insolvency risks that are present
in any swap will depend on the specific facts of the transaction. As a result, an
Agency that has concerns about bankruptcy and insolvency issues should consult
with counsel experienced in this area.
application to tax-exempt financing 39
chapter eight
Tax Issues
A swap entered into in connection with an issue of tax-exempt bonds may impact
certain tax matters relating to those bonds. Specifically, the nature of the swap
structure will determine if the Agency may or must take into account the payments
under the swap in its determination of arbitrage rebate liability in connection with
the bonds.
Section 103 of the Internal Revenue Code of 1986 (the “Code”) provides generally
that income on a state or local government bond is exempt from gross income for
federal tax purposes so long as, among other things, the bond in question is not an
“arbitrage bond” within the meaning of Section 148 of the Code. An arbitrage bond
is generally defined by the Code as “any bond issued as part of an issue any portion
of the proceeds of which are reasonably expected (at the time of issuance of the
bond) to be used directly or indirectly to acquire higher yielding investments ....”
Therefore, the relevant benchmark in determining whether a bond is an arbitrage
bond is the yield on the bond.
The Treasury Regulations under Section 148 of the Code (the “Treasury
Regulations”) provide detailed rules for determining the yield on an issue of bonds,
whether fixed or variable rate. In determining that yield, the Agency is permitted to
take into account certain payments associated with a “qualified hedge.” A hedge is
a contract entered into primarily to modify the Agency’s risk of interest rate changes,
such as an interest rate swap contract.
Amounts paid or received by an Agency pursuant to a swap contract which
meets the definition of a qualified hedge have the effect of increasing or decreasing,
respectively, the yield on the bonds, and accordingly will impact the Agency’s potential
40 interest rate swaps:
arbitrage rebate liability and yield restriction limitations. Amounts paid by an Agency
pursuant to such a swap contract will permit the Agency to invest the proceeds of the
bonds at a higher return. Conversely, amounts received by an Agency will lower the
rate of return an issuer may earn on investments made with bond proceeds.
Qualified Hedges – Regular Integration
For an issuer of bonds to take into account (or “integrate”) payments made or
received on a swap in the determination of bond yield, the swap must meet the
definition of a qualified hedge set forth in the Treasury Regulations. In order to
meet the definition of a qualified hedge, the following factors must be satisfied:
Interest Rate Hedge. The swap contract must be entered into primarily to modify
the Agency’s risk of interest rate changes with respect to a bond.
No Significant Investment Element. The swap contract must not contain a
significant investment element. Generally, a swap contract contains a significant
investment element if a significant portion of any payment by one party relates to a
conditional or unconditional obligation by the other party to make a payment on
a different date. For example, a swap contract requiring any payments other than
periodic payments (such as a payment for an off-market swap), or an interest rate cap
which calls for the Agency to pay an up-front premium, might be determined to have
a significant investment element. If a single
payment for an off-market swap is made
by the Provider to the Agency, however,
the Agency may still treat the swap as a
qualified hedge if: (i) the Provider’s
payment to the Agency and the Agency’s
payments under the swap in excess of those
that the Agency would make if the swap
bore an on-market rate are separately
identified in a certification of the Provider,
and (ii) the payments described in (i) are
not treated as payments on the swap.
Hedge Features to AchieveIntegration:
• Interest Rate Hedge
• No Significant InvestmentElement
• Unrelated Parties
• Contract Covers SubstantiallyIdentical Bonds
• Interest-Based Contract
• Payments Closely Correspond
• Same Source of Payments
• Hedge Must be Identified
application to tax-exempt financing 41
Unrelated Parties. The Agency and the Provider must be unrelated parties.
Contract Covers Substantially Identical Bonds. The swap contract must cover,
in whole or in part, all of one or more groups of substantially identical bonds of the
issue. For example, the contract may cover all of the fixed rate bonds having the same
interest rate, maturity, and terms. The contract may also cover a pro-rata portion
of each interest payment on a variable rate bond issue. This somewhat formalistic
requirement necessitates special drafting when an Agency wishes to hedge only part
of its interest rate risk on particular maturities.
In addition, the issue of bonds resulting after all payments pursuant to the swap
contract are taken into account must also have terms substantially similar to a
bond described in the Treasury Regulations. In the context of variable rate debt
instruments, Agencies are generally comfortable that the terms of the resulting bonds
satisfy this requirement if the variable interest rate on the swap is within, or would
be within, 25 basis points (.25%) of the hedged bonds if otherwise issued as variable
rate bonds.
Interest-Based Contract. The contract must be primarily interest-based. That is
to say, the hedged bonds must, without regard to the swap contract, be either fixed
rate bonds or one of several variable rate debt instruments described in the Treasury
Regulations. In addition, after all payments pursuant to the swap contract are taken
into account as additional payments on the hedged bonds, the terms of the resulting
bonds must be substantially similar to a bond described in the preceding sentence.
Generally, issuers are comfortable that the terms of the resulting bonds are similar
to a variable rate debt instrument if the variable interest rate on the swap and the
interest rate on the hedged bonds are or would be within 25 basis points (.25%) of
each other on the date the swap contract is entered into.
Payments Closely Correspond. The payments received by the Agency from
the Provider must correspond closely in time to either the specific payments being
hedged on the hedged bonds, or specific payments required to be made pursuant
to the bond documents, irrespective of the hedge. These payments might include
payments to a sinking fund, debt service fund or similar fund maintained for the
issue of which the hedged bond is a part.
42 interest rate swaps:
Same Source of Payments. Payments by the Agency to the Provider must be
reasonably expected to be made from the same source of funds that, absent the swap,
would be reasonably expected to be used to pay principal of and interest on the
hedged bonds.
Hedge Must be Identified. While a qualified hedge may be entered into by
either the actual issuer of the bonds or a conduit borrower, the actual issuer must
identify the hedge on its books and records maintained for the hedged bonds not
later than three days after the date on which the hedge contract is entered into.
The identification must contain sufficient detail to establish that the requirements
of a qualified hedge have been satisfied and must specify the Provider, the terms of
the swap, and the hedged bonds. In addition, the hedge transaction must be noted
on the first form relating to the issue of which the hedged bonds are a part that is
filed with the Internal Revenue Service (i.e., the form 8038 or 8038–G submitted
in connection with the issuance of the bonds).
If a swap satisfies all eight of the criteria listed above, the swap is treated as a
qualified hedge, and accordingly payments made or received by the Agency under
the swap are included in the determination of yield on the bonds. A swap satisfying
the definition of a qualified hedge in the Treasury Regulations is terminated upon the
sale or disposition of the swap by the Agency, when the Agency acquires an offsetting
swap, when the bonds subject to the swap contract are redeemed, or when the swap
ceases to be a qualified hedge as discussed above. Upon the termination of a swap
that is a qualified hedge, the Agency must treat any payments received or paid in
connection with the termination as payments made or received on the hedged bonds
for purposes of determining bond yield. If such payments are made by the Agency,
bond yield will be increased; and if such payments are received by the Agency, bond
yield will be decreased.
application to tax-exempt financing 43
Qualified Hedges – Superintegration
Certain qualified hedges relating to floating-to-fixed rate swaps have been accorded
unique tax treatment – although variable rate bonds, the yield on the variable rate
bonds will be treated as a fixed rate yield. While regular integration calls for the
inclusion of payments made or received on a swap in the determination of bond
yield, in these certain cases the bond yield is simply the stated fixed rate of the swap.
These swaps are often referred to as “superintegrated swaps.” Superintegrated
swaps, and the accompanying ability to treat a variable rate bond issue as a synthetic
fixed rate issue, offer several advantages over the normal qualified hedge rules set
forth above.
Because the yield on a fixed rate issue does not change, an Agency may more
effectively plan its investment of bond proceeds, making certain that the yield on its
investments does not violate applicable arbitrage restrictions. An issuer of bonds
seeking to advance refund (i.e., use the proceeds of a refunding bond issue to refund
bonds more than 90 days from the date of issue of the refunding bonds) an older
issue of bonds, where the proceeds of the refunding bonds are invested in an escrow
for a long period of time until the prior bonds can be refunded, will desire certainty
that the yield on the investments in the refunding escrow does not exceed applicable
arbitrage yield restrictions on the refunding bonds. This certainty results from being
able to disregard any differences (so-called basis differences) between the variable rate
on the bonds and the variable rate on the swap.
Finally, because the yield on a fixed yield bond issue is calculated only once, on the
issue date, where true fixed rate bonds and synthetic fixed rate bonds are combined
in a single bond issue, the yield on a synthetic fixed rate issue will usually be higher
during initial computation periods than the yield on a similar variable rate issue. This
44 interest rate swaps:
is because the higher yielding, longer term bonds will have a greater effect in the fixed
yield calculation, as compared to the more limited effect those longer term, higher
yielding bonds would have in initial computation periods in a variable yield calculation.
In order to qualify as a superintegrated hedge, the swap contract must meet the
rules set forth above, as well as the following:
Maturity. The term of the swap contract must be equal to the entire period during
which the hedged bonds bear a variable rate of interest, and the Agency must
reasonably expect that the swap
contract will not be terminated before
the end of that period.
Payments Closely Correspond in
Time. Payments to be received by the
Agency or the Provider under the swap
contract must correspond closely in time to the hedged portion of payments on the
hedged bonds. According to the Treasury Regulations, payments received within 15
days of the related payments on the hedged bonds generally correspond closely.
Aggregate Payments Fixed. After taking into account all payments made and
received under the swap contract, the Agency’s aggregate payments must be “fixed
and determinable” as of no later than 15 days after the issue date of the bonds.
Payments on the bonds are treated as fixed if: (i) payments on the bonds are based
on one interest rate, (ii) payments received on the swap are based on a second
interest rate that is substantially the same as, but not identical to, the first interest
rate, and (iii) payments on the bonds would be fixed if the two rates were identical.
For example, the BMA Index is likely to be substantially the same as an Agency’s
individual 7-day interest rate, and a swap whereby the Provider is required to make
payments to the Agency based on the BMA Index (possibly increased or decreased
by an appropriate spread) should be eligible for superintegration. A more thorough
analysis would need to be undertaken, however, to determine whether a swap under
which the Provider is required to make payments to the Agency based on an index
Additional Hedge Features to Achieve Super-Integration:
• Maturity
• Payments Closely Correspond in Time
• Aggregate Payments Fixed
application to tax-exempt financing 45
which is not a tax-exempt variable rate index (such as a % of LIBOR chosen to
approximate the BMA rate) may be eligible for superintegration.
For accounting purposes, the interest payments an Agency makes on the hedged
bonds are treated as equal to the payments received by the Agency under the
superintegrated swap when calculating the yield on the hedged bonds. Accordingly,
the only payments taken into account in calculating the yield on the hedged bonds
are the payments the Agency makes under the superintegrated swap.
If an Agency terminates a superintegrated swap within five years of the date of
issue of the bonds, the Agency must recompute the yield on the bonds as if the bonds
were originally issued as a variable rate issue. If the swap is terminated after five years
of the date of issue of the bonds, the issue of which the hedged bonds are a part is
treated as if it were reissued as of the termination date of the swap for purposes of
calculating the arbitrage yield on the bonds.
The deemed reissuance or recomputation of arbitrage yield due to the termination
of a superintegrated swap is only applicable for purposes of the arbitrage rebate rules
and does not apply to the rules with respect to yield restrictions set forth in Section
148 of the Code. This distinction is most relevant in the context of an advance
refunding escrow; if the termination of a swap results in a recomputed arbitrage yield
which is lower than the escrow yield, this presents only a potentially positive arbitrage
rebate liability and not a yield restriction violation.
Anticipatory Swaps
Often, an Agency will want to enter into a swap prior to the issue date of its bonds
in an effort to, among other things, hedge against interest rate fluctuations prior to
the bond issuance. This is called an “anticipatory hedge.” The Treasury Regulations
divide anticipatory swaps into two categories: (i) swaps expected to be terminated
upon the issuance of the bonds, and (ii) swaps not expected to be terminated upon
the issuance of the bonds.
46 interest rate swaps:
Swaps expected to be terminated upon the issuance of the bonds.
For swaps expected to be terminated substantially contemporaneously with the
issuance of the bonds, the amount paid or received, or deemed to be paid or received,
by the Agency to terminate the contract is treated as an adjustment to the issue price
and proceeds, respectively, of the bonds. Special rules apply if the swap is not actually
terminated substantially contemporaneously with the issue date of the hedged bonds.
Swaps not expected to terminate upon the issuance of the bonds.
For swaps not expected to terminate upon the issuance of the bonds, the Agency
does not take into account payments made or received before the issuance of the
bonds, but will take into account the payments made after the issue date. Special
rules apply if the swap is, in fact, terminated in connection with the issuance of the
hedged bond.
Anticipatory hedges must, within 30 days of the date the hedge contract is entered
into, meet the identification requirement set forth above and must specify the
reasonably expected governmental purpose, issue price, maturity and issue date of
the hedged bond, the manner in which interest is reasonably expected to be computed
on the hedged bond, and whether the swap is expected to terminate upon issuance of
the hedged bonds.
application to tax-exempt financing 47
chapter nine
Documentation and Negotiation
Documentation
Swap agreements are generally based on the ISDA (International Swaps and
Derivatives Association, Inc.) Master Agreement, which was developed with the hope
of creating uniformity within the market. The Master Agreement itself is a pre-
printed form, and is accompanied by a Schedule and, if applicable, a Credit Support
Annex. The Schedule designates the parties’ elections among options presented in
the Master Agreement, amends Master Agreement provisions as negotiated by the
parties, and addresses additional deal terms not covered by the Master Agreement.
The Credit Support Annex, when present, details collateralization requirements, terms
and mechanics. A Confirmation, detailing the terms of that particular transaction, is
entered into in connection with each trade. An overview of each of these documents
required in a swap agreement is outlined below.
• ISDA Master Agreement – the standardized master legal agreement for all derivativetransactions between the Agency and a Provider that states standardized definitions,terms and representations governing the swap transaction(s).
• Schedule to the Master Agreement – schedule amending or supplementing the ISDAMaster Agreement in order to set out the specific business terms and conditionsgoverning the transaction(s) executed under the agreement.
• Credit Support Annex – document governed by the ISDA Master Agreement whichstates the provisions regarding the mutual posting of collateral, if required, underthe ISDA Schedule to the Master Agreement. The need to post collateral is triggeredby designated events (e.g., if the credit rating of one party drops below an agreedupon rating level, or if the market value of the swap exceeds a threshold for a givenrating level of either the Agency or the Provider).
48 interest rate swaps:
The Master Agreement, Schedule, and Credit Support Annex are designed to
apply to all of a series of swaps entered into between the parties.
Swap documentation can be difficult to read and understand because the basic
documentation forms do not address precisely the legal and business issues particular
to public agencies and tend to be oriented toward the Provider. Additionally, swap
documentation can cover termination event/payment and other real financial risks
to the Agency, which can be narrowed or eliminated through careful negotiation. It
is, therefore, essential that an Agency considering a swap take it as seriously as the
issuance of bonds and be assisted by legal and financial advisors experienced with
municipal swaps.
Major Points of Negotiation
As with any negotiated contract, understanding the needs and perspectives of
the other party, as well as one’s own, is essential to reaching a mutually satisfying
outcome. The process of such negotiations will reflect the relative values assigned
by each party to various structures, with the optimal result that the needs of both
parties are addressed. Because the early termination of a swap can have a significant
adverse impact and because various dispute resolution approaches are unsuitable
for governmental agencies, termination, credit, and dispute resolution issues, for
example, are usually diligently negotiated. The following is a brief list of some of
the points that are often subject to negotiation.
• Confirmation – document governed by the ISDA Master Agreement that is executedfor an individual transaction, itemizing the specific terms and conditions for thatparticular transaction. Each Confirmation contains the pricing terms of the particularswap transaction (e.g., fixed or variable rate, Notional Amount and amortization,termination options) and is executed by the parties at the time of the trade.
application to tax-exempt financing 49
Termination and Credit Related Points
Downgrade Termination. Swap agreements generally allow one party to terminate
the swap at its market value if the other party’s long-term, unsecured debt rating falls
below a given level. This provision allows the non-downgraded party an opportunity
to exit the swap and eliminate its credit exposure to the downgraded party. The
threshold level can vary (below A-/A3 and below BBB/Baa3 are common).
Cross-Default Termination. Swap agreements generally allow one party to
terminate the swap at its market value if the other party defaults on other obligations
of particular types (“Specified Indebtedness”) above a specified size (the “Threshold
Amount”). Specified Indebtedness should be limited to obligations germane to the
sources from which the Agency is obligated to make payments on the swap. The
Specified Indebtedness and Threshold Amount should reflect an order of magnitude
indicating significant financial difficulty in the case of default. It is, therefore, not
uncommon for the Threshold Amount for the Provider (generally a large financial
institution) to be significantly greater than the Threshold Amount for the Agency.
Incorporation of Bond Documents. Swap agreements generally incorporate
provisions of the indenture or other documents pursuant to which the related bonds
are issued or secured. This is appropriate to the extent that the incorporated provisions
are important in securing the Agency’s obligations under the swaps. However, since
any default of an incorporated provision is typically a termination event under the
swap, many provisions of the indenture or other documents (like accounting, notices
filings, maintenance, covenants) are not appropriate for incorporation.
Incipient Illegality. Swap agreements may contain provisions allowing the
Provider to terminate the swap upon the occurrence of an “incipient illegality” (e.g.,
introduction or enactment of legislation, a public declaration by the Agency, etc.
challenging the validity of swaps similar to the Agency’s swap). The rationale is that
if an event occurs that would make the swap agreement invalid, or would assert that
the swap agreement is not a valid obligation of an Agency, the Provider should be
50 interest rate swaps:
empowered to take action before such illegality is in fact formalized. The Agency
must be certain that the definition of incipient illegality is not so broad as to result
in an unwarranted termination of the swap. Thus, events such as a public official
expressing his or her views about swaps in negative terms, the introduction of
resolutions or legislation that are never implemented and would probably not affect
existing swaps in any event, or even judicial cases finding a swap to be invalid in an
unrelated setting, should not be allowed to cause termination due to an overinclusive
definition of incipient illegality.
One-way termination; two-way termination. Two-way termination (non-
defaulting party required to pay defaulting party on termination if non-defaulting
party is out of the money) is the norm for swap transactions, but, since for a public
agency the prospect of an obligation to make a potentially very large unexpected
payment to a defaulting Provider can be politically unpalatable, an Agency may wish
to consider “one-way termination” (only a defaulting party is obligated to pay a
termination payment).
Collateralization. Swap agreements may require a party that is out of the money
above a certain threshold to post collateral or provide for collateralization as an
alternative to termination for credit downgrade. Points of negotiation include the
thresholds at which collateralization will be required (which generally depend upon
the long-term, unsecured debt rating of the party at the time), the types of collateral
permitted, the level of collateralization, and the frequency of valuation. An obligation
to post collateral may present significant financial, and in some cases legal, difficulties
for a governmental agency.
Set-off. A “set-off” provision enables a party that is entitled to a payment under
the agreement (e.g., a termination payment) to satisfy that obligation by reducing the
amount it owes the other party in another transaction. Accordingly, set-off is a way
to manage credit exposure. Set-off would allow a Provider to debit any deposit
accounts the Agency has with the Provider or an affiliate of the Provider to satisfy
amounts payable to the Provider. For public agencies, for whom moneys are not
necessarily interchangeable, a set-off provision can complicate the Agency’s other
business dealings with the Provider.
application to tax-exempt financing 51
Term Out. A “term out” provision allows the Agency to make payments over time
for any amount it may be required to pay upon termination of a swap.
Optional Termination. An Agency should have the right to optionally terminate a
swap at market at any time. The particular mechanics, though, can be the subject
of further negotiation. Typically, Providers can unilaterally terminate the swap
agreement only upon the occurrence of Agency downgrade or default.
Transfer or Assignment. The parties’ ability to assign their rights and obligations
under a swap (e.g., to an affiliate, to another bond indenture) are often heavily
negotiated since an assignment can have major credit implications.
Swap Insurance. Swap insurance provides that the Agency’s payment obligations
under the swap are insured. The terms of such insurance are fairly standardized,
however, the presence of swap insurance can have a significant impact on negotiations
relating to other credit related points described above.
Dispute Resolution Points
Settlement Amount Calculations. When a swap terminates at market, the market
value (i.e., the settlement amount) must be determined. The methodology for such
determination (e.g., “market quotation” vs. “firm bid”) and identification of the party
entitled to manage the process should be described in the swap agreement.
Choice of Governing Law. Providers uniformly ask that swap agreements be
governed by New York law. Providers wish to reduce uncertainty by having their
agreements governed by a single jurisdiction’s law to the extent possible, and
New York has the most developed body of law relating to sophisticated financial
transactions. The Agency may request that issues relating to its power and authority
to enter into the swap be governed by the laws of its home jurisdiction.
Jurisdiction and Venue. Each party would prefer that any dispute arising under
a swap agreement be resolved in its local courts. Silence on this matter or mutual,
non-exclusive jurisdiction are often acceptable compromises.
52 interest rate swaps:
Jury Trial Waiver. Waiver of jury trial is a common provision in sophisticated
financial transactions. Some Agencies, however, have a firm policy against such
waiver, and in some jurisdictions a jury trial waiver may not be enforceable.
Waiver of Sovereign Immunity. Agreements often purport to have the Agency
waive sovereign immunity. As a general matter, the exercise of remedies against
public agencies is governed by state statute, such that procedural and substantive
requirements cannot be waived by contract. A representation that remedies are
available should be sufficient.
application to tax-exempt financing 53
chapter ten
After the Close:Post-Trade Management
From hedging interest rate risks to lowering borrowing costs to introducing
flexibility into an Agency’s overall debt management strategy, the economic
motivations for developing and implementing a comprehensive swap strategy are
clear. Part of such a strategy should be well conceived plans for (i) monitoring
the performance and effectiveness of the swap, (ii) accounting for a changing
valuation and position of the swap, and (iii) periodically disclosing consistently
the associated terms and risks.
Financial Management
When initially structured, a given swap will contain a stated termination date.
This is the date through which the swap will remain in effect in the absence of any
voluntary or involuntary termination under the swap documents. However, an
Agency should not simply assume that all will go as planned, or that the scheduled
termination date will or should be reached. Rather, procedures should be in place
to monitor the potential advantages of a negotiated (voluntary) termination, and to
monitor the risks and consequences of any other kind of early termination.
It is important that an Agency that makes use of swap structures have a strategy
in place for monitoring changes in the interest rate environment. Changing market
conditions will impact the effectiveness and value of a swap, and may even create
opportunities for terminations or restructurings with substantial payments to the
Agency from the Provider or with terms more favorable to the Agency. As with other
54 interest rate swaps:
financing structures, swaps are very sensitive to changing market conditions and a
successful swap strategy should allow for quick action to take advantage of favorable
market conditions while those conditions still exist.
Two other examples of options that may present themselves given interest rate
environments different from those at the time a swap commenced, are (i) reversing
or layering an offsetting swap on top of an existing swap and (ii) changing the
underlying basis or index of an existing swap. In both examples, the Agency that is
prudently monitoring existing swap positions may be able to either realize substantial
monetary gains or improve the economics of their original swap.
Risk Monitoring
In addition to monitoring for financial strategy and planning reasons, an Agency
should also monitor changing business risks, such as those outlined in Chapter Five.
While each of those risks is considered at the time a swap is structured, changes in
market conditions, counterparty creditworthiness, and even the tax and regulatory
environments might effect a change in how the Agency values and accounts for the
swap. In the case of counterparty solvency, it is important that the Agency develops
a plan of action in the case of downgrade or other rating triggers or, in the extreme,
an event calling for an early termination of the swap. Similarly, the Agency may
have its own obligations if its ratings are downgraded or it suffers other changes to
its financial condition. Markets and circumstances can change rapidly, and it can be
costly for an Agency to be caught reacting to changes after they occur (even if they
effect directly only the Provider) without monitoring procedures and plans in place.
Accounting and Disclosure
Before the introduction of FASB 133 (“Accounting for Derivative Instruments
and Hedging Activities”) and GASB Technical Bulletin No. 2003–1 (“Disclosure
Requirements for Derivatives Not Reported at Fair Value on the Statement of Net
application to tax-exempt financing 55
Assets”), swaps were off-balance-sheet transactions and there was very little consistency
regarding how swaps were accounted for or reflected in financial statements, if
recognized at all. With the introduction of FASB 133 and GASB Technical Bulletin
No. 2003–1, an Agency using swaps in connection with the issuance of tax exempt
debt should be aware of the additional accounting and disclosure requirements for
swaps and the potential impact on its balance sheet. Unlike in the case of accounting
for traditional outstanding bonds, an Agency using swaps must generally account for
and reflect the performance of its swap portfolio in its financial statements.
Under FASB 133, Agencies reporting financial results under FASB guidelines must
report payments made and received under a swap with interest expense on the balance
sheet. Furthermore, all swaps must be recorded as assets or liabilities (depending on
whether the swap is in a gain or loss position) at fair market value. Unrealized gains
or losses for a given period must be reflected in the earnings for that period. In
volatile environments, this can result in large differences from one period to the next.
There may be an opportunity, however, if a given swap qualifies as a “cash flow
hedge,” for the Agency to make use of hedge accounting, thus reducing some of the
impact of changes in unrealized gains and losses on earnings statements. An Agency
desiring to make use of such hedge accounting should be certain to consult with the
proper experts before entering into a swap agreement so as to be sure the swap meets
the necessary requirements.
For Agencies reporting under the guidance of GASB, GASB Technical Bulletin
No. 2003–1 outlines a number of items which should be disclosed in the financial
statement notes for swaps not reported at fair market value on the balance sheet on
a given reporting date:
Objective – The Agency should disclose its objectives in entering into the swap, and
its strategies in achieving those objectives. Also to be disclosed is the broader context
leading to the development of those objectives.
Significant Terms – The Agency should disclose significant terms of the swap, such
as Notional Amount, interest rates, other financial terms and options, the effective
date, and scheduled termination date.
56 interest rate swaps:
Fair Value – The Agency should disclose the fair market value of the swap, as well as
the methodology for determining that value.
Risks (e.g., basis, termination) – The Agency should disclose its updated exposure
to various risks through use of the swap, including those outlined in Chapter Five, as
well as changing interest rate risks and market access risk.
Associated Debt – In the case that the swap is associated with an underlying
debt obligation, the net cash flow of the swap should be disclosed along with the
requirements of the underlying debt.
Swaps may have a significant impact on an Agency’s overall financial position and
may present risks material to the holder or purchasers of an Agency’s bonds. An
Agency must take care, therefore, to insure that its swaps and attendant risks are
adequately disclosed in official statements and continuing disclosure reports. In order
to comply with their financial reporting obligations, Agencies need to have in place
a mechanism to periodically value (mark-to-market) swaps for annual and internal
account purposes, in addition to the other purposes set out in this Chapter Ten.
application to tax-exempt financing 57
glossary of key terms
Agencies—For the purposes of this booklet,issuers of tax-exempt debt and otherentities that have access to the municipalcapital markets.
Arbitrage—For federal tax law purposes,the resulting dollar amount, positive ornegative, generated by an Agency investingtax-exempt bond proceeds at interest ratesabove (positive arbitrage) or below (nega-tive arbitrage) the rate an Agency is payingon an issue of tax-exempt debt obligations(see arbitrage yield).
Arbitrage Yield—For federal tax law pur-poses, the yield on an issue of tax-exemptdebt obligations used to calculate theamount of arbitrage earned, positive ornegative, by an Agency.
Assignment—The transfer of a party’srights and obligations under a swap toanother party.
Basis Risk—The risk of a mismatchbetween an Agency’s floating rate receipt(or payment) on a swap and its floating ratepayment (or receipt) on the underlying debt(or asset) as a result of different indices orterms being used to determine paymentsand receipts.
Basis Spread—The difference in interestrates between an Agency’s floating ratereceived (or paid) on a swap and its floatingrate paid (or received) on the underlyingdebt (or asset), which results from differentindices or terms being used to determinepayments and receipts.
Basis Swap—A floating-to-floating rateswap in which one variable rate index isswapped for another; commonly used tomodify basis risk.
Bid Date—In a competitive bid transaction,the date on which swap Providers submitbids and the swap entered into with thewinning Provider is priced.
Bid Package—Documentation packagedistributed by or on behalf of an Agency to qualified Providers, detailing the termsand structure of the swap desired by theAgency, which the Providers will use to for-mulate their bid on the scheduled bid date.
BMA Index—The BMA Municipal SwapIndex (formerly the PSA Municipal Swap Index), is the principal benchmark for the floating rate interest payments fortax-exempt issuers. The BMA Index is anational rate based on a market basket of(approximately 250) high-grade, seven-daytax-exempt variable rate demand obligationissues of $10 million or more.
Cap—A financial contract under which theProvider, in exchange for charging a setpremium, will make payments to the Agencywhenever and to the extent the interest rateon the Underlying exceeds a specified strikerate, also known as the cap rate.
Change in Tax Law Risk—The risk that therewill be an unanticipated structural changeto current tax laws, which would impact thespread between tax-exempt and taxablerates.
Collar—A combination of an interest ratecap and an interest rate floor.
Collateralization Risk—Risk that thecircumstances under which an Agencywould have to post collateral pursuant tocertain swap agreement provisions willarise in the future.
58 interest rate swaps:
Competitive Bid—Process of entering into a swap agreement where interested swapProviders submit bids to the Agency on aspecified date, and the swap is entered into with the winning Provider; usually theProvider offering the interest rate termsmost favorable to the Agency.
Confirmation—Document governed by theISDA Master Agreement that is executed for an individual transaction, itemizing thespecific terms and conditions for thatparticular transaction.
Cost of Funds—Refers to an Agency’s actualinterest rate cost on its debt obligations,which may or may not include carryingcosts such as remarketing fees, liquidityfees, letter of credit fees, etc., that issometimes used as the Underlying in aswap transaction.
Cost of Funds Swap—A swap under whichthe Floating Leg receipts match the interestpayments due on the underlying debtexactly.
Counterparty—A party in a swap transac-tion. From an Agency’s perspective, this issynonymous with Provider.
Counterparty Credit Risk—The risk that aparty to a swap will not be able to meet allof its financial obligations under the swap.
Credit Penalty—The additional require-ments (e.g., a higher interest rate,additional insurance, etc.) of a party to aswap imposed due to that party’s lowercredit rating.
Credit Support—Collateral that can be in the form of cash and/or marketablesecurities posted by one party to a swapagreement to reduce the credit exposure ofits counterparty. See also Swap Insurance.
Credit Support Annex—Document governedby the ISDA Master Agreement which statesthe provisions and circumstances underwhich posting of collateral is required.
Cross-Default Termination—The ability ofone party to terminate the swap at itsmarket value if the other party defaults onother obligations of particular types.
Downgrade Termination—Provision in someswap agreements allowing one party toterminate the swap at its market value ifthe other party’s long-term, unsecured debtrating falls below a given level.
Effective Date—The first date on whichpayment obligations begin to accrue,including the date any upfront payment isexchanged. In the case of a forward swap,payment accruals may not begin for monthsor even years into the future. When a swapis entered into in connection with an issueof bonds, the Effective Date is often set tocoincide with the issue date of the bonds.
Exercise Period—In an option contract, the period of time in which a party has theright to exercise its option and effect a pre-negotiated transaction.
FASB—Financial Accounting StandardsBoard.
Fixed Leg—In a swap transaction, the pay-ments made by one party to another basedon a pre-determined fixed interest rate.
Fixed Rate Swap—A swap, under which an Agency pays a Provider a fixed rate inexchange for receiving a floating rate; mostcommonly used to convert variable ratebonds into synthetic fixed rate obligations.
Fixed-to-Floating Rate Swap—See floatingrate swap.
application to tax-exempt financing 59
Floating Leg—In a swap transaction, thepayments made by one party to anotherbased upon a pre-determined floating(variable) rate index.
Floating Rate Swap—A swap, under whichan Agency pays a Provider a variable rateand receives a fixed interest rate; usuallyassociated with an issue of fixed rate bondsthat an Agency wishes to convert to asynthetic floating rate.
Floating-to-Fixed Rate Swap—See fixedrate swap.
Floor—A financial contract under which anAgency will make a payment to the Providerwhen the Underlying falls below the pre-determined strike rate, or floor rate.
Forward Rate Curve—The yield curve, as of a future (or forward) date, constructedusing currently prevailing rates on instru-ments settling in the future; commonlyused to price many interest rate derivativeinstruments.
Forward Swap—An interest rate swapunder which the accrual and exchange ofcash flows commences at a later date,rather than the current date.
GASB—Governmental AccountingStandards Board.
Hedge—A tactic (or a financial product)used to limit potential losses or gains asso-ciated with an existing financial position,asset or liability. Also see Perfect Hedge.
In the Money—Refers to a party’s financialposition if it would be owed a payment bythe other party if a swap were terminatedat the prevailing market price.
Integration—For tax law purposes, theability of an issuer of bonds to take intoaccount (or “integrate”) payments made orreceived on a swap in the determination ofbond yield.
Interest Rate Risk—The risks associatedwith changes in interest rates (i.e., the riskthat changes in interest rates will adverselyeffect an Agency’s position with respect toborrowing costs, re-investment opportuni-ties, at-market investment termination, etc.)
Interest Rate Swap—A contractual agree-ment between two parties who agree toexchange certain cash flows, calculated atdifferent interest rates, for a defined periodof time.
ISDA—International Swaps and DerivativesAssociation, Inc.
ISDA Master Agreement—The standardizedmaster legal agreement for all derivativetransactions between an Agency and aProvider that states standardized defini-tions, terms, and representations governingthe swap transactions.
LIBOR—London Inter-Bank Offered Rate isthe interest rate banks charge each otherfor short-term money, up to a 12 monthterm. LIBOR is commonly used as theUnderlying for the Floating Leg of a Swap.The British Bankers’ Association (BBA) sets the rates daily.
Mark-to-Market—Calculation of the valueof a financial instrument (e.g., an interestrate swap) based on the current marketrates or prices of the Underlying.
Negotiated Bid—Method of entering into aswap agreement where the terms, includingthe rates, are negotiated between anAgency and the Provider.
60 interest rate swaps:
Notional Amount—Similar to bond principalamount; used as the basis to determine theamount of swap interest payments. TheNotional Amount will often amortize overtime to match the amortization of thebonds to which the swap is related.
Off-Market Swap—A variation of an interestrate swap in which one or both of thereferenced rates are priced above or belowthe market, usually resulting in an up-frontpayment from one party to the other.
Option Premium—The amount paid by aparty in exchange for an option.
Optional Termination—The right of a partyto terminate a swap at any time at theprevailing market price. In most swapagreements only the Agency has this right.
Out of the Money—Refers to a party’sfinancial position if it would owe a paymentto the other party if a swap were terminatedat the prevailing market price.
Perfect Hedge—A hedge that completelyeliminates any possible future gain or losson the hedged asset or liability.
Provider—For the purposes of this booklet,the financial institution that enters into aswap agreement with an Agency, usually a commercial bank, investment bank, orinsurance company.
Rate Lock Agreement—An arrangementunder which an Agency enters into anagreement with an underwriter to issuefixed rate bonds in the future, at a pre-determined net interest cost.
Schedule to the Master Agreement—Schedule amending or supplementing theISDA Master Agreement which sets out the specific business terms and conditionsgoverning the transactions executed underthe agreement.
Set-off—Swap provision that enables aparty that is entitled to a payment underthe agreement (e.g., a termination payment)to satisfy that obligation by reducing theamount it owes the other party in anothertransaction.
Strike Rate—In an interest rate cap orinterest rate floor, the pre-determinedinterest rate that, when reached in themarket, automatically triggers a paymentunder the contract.
Swap Curve—The name given to the swap’sequivalent of a yield curve. The swap curveidentifies the relationship between swaprates at varying maturities.
Swap Insurance—Insurance policy pur-chased to guarantee obligations on a swap,which can be underwritten to insure onlythe regularly scheduled payments underthe swap, or also any termination paymentthat may be required under the swap.
Swaption—A type of swap in which theterms of the swap are agreed to in advanceand where one party has the right, but notthe obligation, to enter into that swap on afuture date or during a specific period.
Synthetic Fixed Rate—The resulting rate anAgency will pay on an issue of variable rateobligations after entering into a floating-to-fixed interest rate swap.
application to tax-exempt financing 61
Synthetic Floating Rate—The resulting ratean Agency will pay on an issue of fixed rateobligations after entering into a fixed-to-floating interest rate swap.
Tax Risk—The risk that the spread betweentaxable and tax-exempt rates will change asa result of changes in income tax laws orother conditions.
Term Out—Provision of a swap agreementthat allows the Agency to make paymentsover time for any amount it may be requiredto pay upon termination of a swap.
Termination Date—The scheduled maturitydate of the swap, when the final paymentobligation is made (barring an early termi-nation of the swap). When a swap isentered into in connection with an issue ofbonds, the termination date is often set tocoincide with the maturity date of the bonds.
Termination Events—Events that allow forthe termination of a swap, such as a creditdowngrade.
Termination Payment—Payment made fromone counterparty to the other if the swap isterminated prior to its scheduled termina-tion date.
Trade Date—The date on which swap termsare set and the agreement is priced; formaldocuments are sometimes exchanged sometime later. Also called the Sale Date.
Underlying—The variable interest rate,security price, commodity price, or index of prices or rates on which the derivative’spayments are based. A derivative’spayment is based on the interaction of theUnderlying and the Notional Amount.
62
ABOUT THE AUTHORS
Orrick, Herrington & Sutcliffe LLP
Orrick, Herrington & Sutcliffe LLP (“Orrick”) is an international law firm with nearly 675lawyers located in North America, Europe, and Asia. We focus on litigation, complex andnovel finance, and innovative corporate transactions. Orrick has a commitment to publicfinance stretching back nearly a century. For the past decade, Orrick has ranked No. 1 inthe country as bond counsel and as underwriter’s counsel, averaging a combined marketshare of approximately 12 percent of all municipal debt obligations issued each year.
Roger L. Davis(415) [email protected]. Davis is Chair of Orrick’s Public Finance Department. He wrote and lobbied thelegislation in California and in several other states authorizing the state and local governmentsto enter into swaps and other hedging instruments. Mr. Davis regularly serves as bondcounsel or swap provider’s counsel on transactions involving swaps and other hedginginstruments, and is a frequent speaker on these topics.
Stephen A. Spitz(415) [email protected]. Spitz is a partner in the Public Finance Department of Orrick, Herrington & SutcliffeLLP. He has served as bond counsel on numerous transactions involving swaps and otherderivative products. Mr. Spitz is the head of Orrick’s opinion committee on swaps.
Albert Simons III(212) [email protected]. Simons is a partner in the Public Finance Department at Orrick. He has broadexperience in the areas of municipal derivative products and refundings, including syntheticrefundings through the use of swaps. Mr. Simons has over 15 years of experience withinterest rate swaps, representing both users and providers.
George G. Wolf(415) [email protected]. Wolf is Chair of Orrick’s Tax Department. As the leading national authority onmunicipal derivative products, he has extensive experience in working with leading banks to create new financial products, including secondary market synthetic instruments.
Bond Logistix LLC
Bond Logistix LLC (“BLX”) is a consulting and SEC registered investment advisory firm.Focused on the needs of state and local governments, Bond Logistix offers a comprehensiverange of financial and consultative services to the public finance community. As an advisorand consultant to hundreds of state and local governments, BLX provides all-inclusive swapadvisory services from concept to post trade management, including assistance in evaluating,acquiring, and terminating various interest rate swaps and related products.
Craig Underwood(213) [email protected]. Underwood joined BLX’s predecessor organization in 1989 and became its chiefexecutive in 1998. In addition to being co-head of the swap advisory practice, he serves asPresident of BLX and chair of its management committee, and is ultimately responsible forthe overall management of and strategic planning at BLX. Mr. Underwood is a frequentlecturer on swap, investment, and arbitrage-related bond proceeds investment matters, is a co-author of the California Debt and Investment Advisory Commission’s Debt IssuancePrimer and a member of numerous governmental and municipal finance associations.
Eric H. Chu(415) [email protected]. Chu is a Managing Director in BLX’s San Francisco office. He oversees the BLXInvestment Advisory Practice area that develops and implements specialized investmentvehicles (or structured products) tailored to the needs of municipal entities. In addition, heco-heads the firm’s swap advisory practice and is a member of BLX’s management committee.
Thomas B. Fox(415) [email protected]. Fox is an Associate Director in the San Francisco office of BLX where he leads thefirm’s business development efforts in Northern California and the Pacific Northwest.He is also the head of BLX’s nationwide Single Family Housing practice. Mr. Fox is amember of several industry organizations in Washington, Alaska, California, and Oregonand frequently speaks at various conferences and meetings.
Jon A. McMahon(415) [email protected]. McMahon is a Financial Consultant in BLX’s Investment Advisory Practice. Prior tojoining the San Francisco office’s Investment Advisory Practice, he served as a consultant on arbitrage rebate liability, performing over 275 arbitrage rebate analyses for numerousmunicipal issuers.
www.bondlogistix.com www.orrick.com